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Price effect vs Impermanent loss
What is the difference between price effect and impermanent loss? How to use "Return incl. Price Effect" and "Return incl. Impermanent Loss"?
Price effect refers to the net equity value change due to changes in asset prices in the liquidity pool, compared to your principal. It might be positive or negative, depending on token price fluctuations and trading fee rewards in the pool.
Impermanent loss refers to the "loss" when you deposited your assets to a liquidity pool to get a share in the pool (LP-tokens) followed by tokens' price change, compared with simply holding the assets on hand. It is the result of fluctuations in the underlying value of the assets being swapped, and happens whenever the relative price of the tokens changed. It is always negative.
Please note that price effect is focusing on ACTUAL price change while impermanent loss is focusing on RELATIVE price change. Thus, it’s possible to achieve 0 impermanent loss but high price effect for the liquidity provision.
Here are two examples for illustration, but please note that the values here do NOT account for trading fee rewards for simplicity's sake.
Consider the liquidity pool CRO-USDC LP, with USD2,000 principal
Assume CRO/USDC = 0.5 on day 1
(# of CRO) x (# of USDC) = constant
Consider the liquidity pool CRO-SINGLE LP, with USD2,000 principal
Assume CRO/USDC = 0.5 and SINGLE/USDC = 0.25 on day 1
(# of CRO) x (# of SINGLE) = constant
In LP Time Machine, we provide different angles for various users to analyze their farming positions.
Users who use yield farming as a tool to earn farming profit and wish to measure earning in USD should use "Return incl. Price Effect"..
VVS-WCRO farming pair in VVS (21 May 2022 - 20 Jun 2022)
Referring to above performance chart, the net equity value change in USD (purple line) is highly related to the changes of asset prices (pink bars) in the liquidity pool. As both tokens experienced a large drop during the period, the position recorded a large value deduction accordingly. Although the position generated stable trading fee and yield farming rewards, it could not cover losses due to Price Effect.
Some crypto investors focus on the long term development of the protocols/tokens, and care less about the short term price fluctuation of their favorite tokens. For these users who wish to just hodl in diamond hand, it is more suitable to use "Return incl. Impermanent Loss" for analysis instead.
In this view, the chart demonstrates the performance of yield farming on top of pure asset holding (i.e. do nothing with the tokens). As it is assumed the investors have originally owned the farming tokens and they do not intend to sell them shortly, the cost of purchasing respective tokens (i.e. sunk cost) is thus not considered. Referring to above performance chart, the trading fee and yield farming rewards generated by yield farming far surpasses the impact on impermanent loss. Therefore, it is more beneficial to execute yield farming than to purely hold the assets.